What are the implicit interest rate and the incremental borrowing rate under IFRS 16?
Under IFRS 16, lease contracts are recognised by measuring the present value of future lease payments. The interest rate applied depends on the structure of the lease contract and the availability of relevant information. This article explains the difference between the implicit interest rate and the incremental borrowing rate.
What does a lease contract consist of?
When lease contracts are recognised under IFRS 16, they are classified as either operating or finance leases. This often raises questions about which interest rate should be applied: the implicit interest rate or the incremental borrowing rate. Which rate applies to each type of lease? To understand the difference, it is first necessary to understand how a lease contract is structured.
A lease contract always consists of five core components, in addition to insurance and other add-ons:
An asset with a purchase price
A defined lease term
An interest rate
A lease payment
A residual value
Under IFRS 16, future lease payments must be measured at their present value. Depending on whether the lease is classified as an operating or a finance lease, either the implicit interest rate or the incremental borrowing rate is applied. This is explained together with Richard Nilsson, an IFRS 16 expert.
Operating leases and the incremental borrowing rate under IFRS 16
For operating leases, only two components are known: the lease term and the lease payments.
– In order to measure an operating lease, certain assumptions therefore need to be made. It is assumed that the residual value is zero, no purchase price is set, and that no liability remains at the end of the lease term. To calculate the present value, an interest rate must then be determined – the so-called incremental borrowing rate, Nilsson explains, and continues:
– The incremental borrowing rate is an estimated rate intended to reflect the interest rate the company would have incurred if it had borrowed the funds to finance the asset instead. For example, if a company leases a car for 36 months, what interest rate would have applied if the car had instead been purchased on credit? This is an estimate – a ‘best guess’ or a reasonable interest rate assumption. In summary, the standard does not prescribe a fixed method for determining this rate. Instead, the auditor or the company must justify the assumption, for example based on market interest rates, creditworthiness, or the group’s internal borrowing rate.
Finance leases and the implicit interest rate under IFRS 16
For finance leases, the interest rate is known. It is derived from the other contractual parameters and is referred to as the implicit interest rate.
– This is the interest rate that is effectively ‘embedded’ in the lease contract, calculated based on the purchase price, lease payments, lease term, and residual value, Nilsson explains.
Summary: implicit interest rate vs. incremental borrowing rate
Implicit interest rate: the actual interest rate that can be derived from a finance lease contract.
Incremental borrowing rate: an estimated interest rate used when the implicit interest rate cannot be readily determined, primarily for operating leases under IFRS 16.